Valuing Closely Held Stock for Estate and Gift Tax Purposes

The courts and IRS agree: Potential capital gains reduce stock value.

PAs who work with estates know that, if a
decedent owned stock of a closely held business at his or
her death, the value of the stock generally must be
determined if an estate tax return will be filed. The value
for such purposes is the date-of-death fair market value
(FMV) (or, if an election is made under IRC section 2032,
the FMV on the “alternative valuation date,” six months
later). The same is true for gifts of closely held stock—the
FMV on the date of the gift must be determined for gift tax
purposes.

BACKGROUND

The
valuation issue is not much of a problem when stock is
publicly held because a CPA can readily obtain the
date-of-death (or date-of-gift) FMV from a newspaper or
broker and multiply it by the number of shares owned or
gifted. However, closely held stock usually does not have a
readily ascertainable FMV: There may be only a few shares,
they may not be widely traded (and, indeed, may never have
been traded), and only a few family members may be holding
them. In addition, other factors may apply, such as
applicable discounts and premiums that affect FMV—for
example, owning a minority or controlling block of
shares—and the availability to an estate of the section 2057
qualified family-owned business deduction. While revenue
ruling 59-60, 1959-1 CB 237, outlines the general approach
to valuing closely held stock for estate and gift tax
purposes, it also states that the determination of FMV
depends on the facts and circumstances.

Normally,
expert appraisers are hired by tax advisers to value the
stock; sometimes, if the IRS does not agree with the value
reported on the return, litigation ensues. Thus, when the
courts and IRS agree that certain reductions in closely held
stock value are permissible, CPAs should take notice.

Recently, the Second Circuit Court of Appeals held that
the per-share valuation can be reduced for potential capital
gains on corporate liquidation, or on a distribution or sale
of its capital assets (for example, real estate). The IRS
later acquiesced, agreeing such a reduction is valid. The
Sixth Circuit later weighed in with an opinion of its own. A
review of these rulings illuminates the thinking on this
issue.

SECOND CIRCUIT

In
Irene Eisenberg (155 F.3d 50, 2d Cir. 1998,
revk’g and remd’g TC Memo 1997-483), the taxpayer owned all
1,000 shares of a corporation whose sole asset was a
commercial building it rented out. The taxpayer gave shares
of the corporation to her son and two grandchildren in 1991,
1992 and 1993: In valuing the stock for gift tax purposes,
she reduced the FMV by the full capital gains tax she would
have incurred in the event of corporate liquidation, or a
sale or distribution of the building, even though, at the
time of the gifts, the corporation had no such plans.

The IRS disagreed with the gift tax valuation,
contending solely that the value of the stock could not be
reduced for potential capital gains tax. The taxpayer
petitioned the Tax Court, which held against her.

The court reasoned that firmly established precedent
dictated no reduction in stock value for potential capital
gains tax in the absence of evidence that a corporate
liquidation—or a sale or distribution of capital gain
assets—was likely to occur. In the court’s view, such tax
liability was purely speculative. Further, the taxpayer
failed to show that a hypothetical buyer would purchase the
corporation with an eye towards liquidation or selling
assets so that the potential capital gains tax liability
would be a material or significant concern.

CPAs should attach a
disclosure statement to the estate or gift tax
return that details how the closely held stock’s
value was reduced for capital gains tax liability.

The taxpayer appealed the
decision; the Second Circuit held that she was entitled to
reduce stock value for potential capital gains tax
liabilities, even though no liquidation, or asset sale or
distribution, was contemplated by the corporation when the
stock was gifted. According to the court, such a reduction
takes into account whether a hypothetical willing buyer of
the stock, having reasonable knowledge of the relevant
facts, would take some account of the tax consequences of
contingent built-in capital gains in making a sound
valuation of the property.

The IRS later acquiesced
in Eisenberg (see IRB 1999-4, 4); it agreed that
the FMV can be reduced, for estate or gift tax purposes, by
the potential capital gains tax liability. However, the IRS
requires the taxpayer (for gift tax purposes) or the estate
(for estate tax purposes) to offer sufficient evidence as to
the computation of the discount.

SIXTH CIRCUIT

In
Estate of Pauline Welch (6th Cir., 3-1-00, rev’g
and remd’g TC Memo 1998-167), an unpublished opinion, the
court held that an estate could present evidence of the
appropriate amount a hypothetical willing buyer and seller
would consider as a discount or adjustment in valuing the
stock, based on the built-in capital gains on the
corporation’s real estate.

In Welch, the
taxpayer had owned minority interests in two closely held
corporations; at her death, the stock passed to her
children. The value of the stock on her estate tax return
was reduced for the capital gains tax liability on the
corporate real estate and for the decedent’s minority
interests. The IRS disputed the reduction for capital gains
taxes; the estate appealed.

The Sixth Circuit,
explicitly adopting an Eisenberg analysis, held
that such valuation reduction was available; it further held
that the corporations’ option to defer capital gains tax
under section 2033, for real estate potentially subject to
condemnation, did not bar a valuation discount for estate
tax purposes. The Sixth Circuit thus reversed and remanded
the case to the Tax Court for a hearing on the price a
hypothetical buyer would pay for the stock.

COMPLIANCE STRATEGY

CPAs working with gift and estate tax valuation issues
for closely held stock should keep these decisions and the
IRS’s acquiescence in mind when computing closely held stock
FMVs on estate or gift tax returns. Because the IRS agrees a
discount is appropriate, it does not matter whether the
taxpayer or estate is located within the jurisdiction of the
Second or Sixth Circuits; the principle applies nationwide.
However, a CPA should attach a disclosure statement to the
estate or gift tax return detailing the capital gains tax
liability computation that reduced the stock valuation.

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